Crucial Issues in Ukrainian Natural Gas Prices and Distribution System

The present paper aims to provide a detailed analysis of the natural gas distribution system in Ukraine, since it has recently become one of the most critical problems for the Ukrainian gas market. During the last years the Ukrainian government has adopted a number of very important regulatory changes in the gas sector as a whole, and gas distribution sector, in particular, including new Gas market Law, Gas distribution system Code, and Standard natural gas distribution contract. Still, a lot of work in this field remains to be done. This paper underlines tariffs’ levels and their structure, tariff regulations and operational efficiency of distribution system operators in Ukraine. Furthermore, the report gives proposals on possible ways the current situation can be solved or improved.

Ukrainian gas distribution system is regulated by The National Commission for State regulation in the Energy and Utilities (NEURC) mainly by legal regulation, licensing of the DSOs, pricing and tariff policy, and state control and enhancement. The fact that the gas distribution industry is considered to be a natural monopoly, the primary task of the NEURC, as the national regulatory authority, is to balance the interests of all gas market participants. That is to prevent the monopolist to overcharge customers and to set non-discriminatory and cost-reflective distribution tariffs that should be sufficient enough to ensure necessary investments in the networks. However, current situation on Ukrainian gas market is quite different. During past five years share of distribution tariffs in the retail gas prices structure has reduced from 33% to 8%, , including the fact that inflation index during that period was nearly 227 % .

For the distribution tariff setting Ukrainian regulator applies rate of return regulation, also known as “cost plus” regulation that is based on simple principle on covering DSOs recognized costs including reasonable profits. Planned expenses are based on reported data for the preceding year with an adjustment for price inflation. However, such regulatory method is non-effective mainly because it can hardly meet key regulatory objectives and provides limited incentives to DSOs to improve cost efficiency or to increase quality of service.

The current level of gas distribution tariffs which were lastly set in 2016, does not allow Ukrainian DSOs to cover justified costs, invest additional capital in the network grid and has caused incredible losses. Such situation evidences an ineffective pricing and tariff policy in the energy sector. It is generally accepted that the regulator setts tariffs on the basis of the reported data for the preceding year, moreover, tariff review procedure may be reopened by the NEURC on its own initiative when the tariffs do not cover more than 5% of the actual costs of the DSOs. Since 2014, due to unjustified tariffs, Ukrainian DSOs have suffered losses of more than 4 billion UAH .

The networks can suffer from gas losses during operation, thus lowering their efficiency and increasing costs of operation. Losses can occur due to multiple reasons: pipe leaks, equipment damage, measurement errors, stolen gas and accounting errors. Some gas pipes may also require technical maintenance. Gas distribution networks with high losses may not only increase costs for consumers, but may also pose safety concerns if excessive pipe leaks are present.

Ukraine predefines the volume of gas losses that are allowed to be recovered from the tariff paid by consumers. The levels of losses vary across the regions and are set individually for each one. The procedure to define the losses for the distribution networks requires three steps. First, the network operators submit a proposal to the Ministry of Energy for planned losses in the following period (one year). The norms for expected gas losses for each piece of equipment are set by the Ministry of Energy on the basis of Ukraine’s construction norms and were developed using technical standards for gas equipment.

However, the numbers based on the current methodology are not representative of the actual losses – on average the calculated losses are about 70% above the actual losses! The calculated losses are evaluated by the Ministry and in most cases significantly downwards adjusted.

In the last step of the procedure, planned volumes of gas losses are evaluated by the NEURC and the tariffs are confirmed with the consideration of the set losses. In most of the cases, the projected losses are not changed significantly by NEURC, but rarely can be adjusted downward. On average the losses confirmed in the tariff were about 11% lower than the actual losses; however the differences can be quite large for individual operators. For eight operators the actual losses were more than 30% higher than the confirmed ones. In such cases the companies have to cover the extra losses out of their own budget.

Still the NEURC has to ensure that the distribution companies can earn a proper return on investment. Typically, distribution system operators are allowed either to fully recover all losses or a predefined “reasonable” amount. Identifying the “reasonable” amount for losses and setting up a system that encourages efficiency of distribution systems is a major task for regulators. The NEURC regulates the cost of losses not only through volumes, but through the price for gas. The cost of gas losses for DSOs was last set in 2015 at an average price nearly 6 000 UAH, when current price is nearly 11 000 UAH. So, unjustified cost of network losses is one of the dominant factors which caused huge losses of the gas distribution sector.

So, the current cost-plus regulation is backward looking, does not provide efficiency incentives, and may not provide for sustained cost recovery. Thus, Ukraine should move towards a revenue regulation based on RAB, likewise the majority of European countries. For example, revenue caps applied in the Czech Republic and France could serve as best practice examples and help identify areas of improvement.

The necessary steps to improve cost effectiveness of the Ukrainian DSOs are the following:

• To increase efficiency and drive losses down, DSOs should be allowed to invest in network replacements and metering, and be rewarded via adequate rate of return on their assets, reflected in their tariffs.
• NERC can consider allowing large unfinished investments in RAB, as a measure of capex incentivization.
• NERC, the State and the DSOs should reach an agreement concerning the completion of unfinished publicly funded distribution network investments.
• NERC should consider allowing ex-post correction within the regulatory period, for changes in investment plans and for any differences that may arise between planned and actual RAB in individual years, so as to incentivize DSOs to adjust their investment plans according to market conditions.
• NERC should participate in the setting of the maximum WACC for the gas sector.
• Efficiency factors could be enhanced based on best practices, and should include indicators linked to quality of services (e.g. appointments missed by the DSO, new connections completed, number of meter readings, etc.) and innovation.
• NERC should consider revising the incentive factors linked to quality of service and customer satisfaction as they are currently narrow in focus and imbalanced (i.e. include only penalties in the form of revenue requirement adjustments (decreases) for non-performance/failure to comply).

A significant component of losses in Ukraine arises from the conversion of gas volumes from normal to standard conditions. According to EU practice, this type of loss is nevertheless part of the supply gas cost and not part of DSO costs. The conversion of residential measurements to standard volumes, in line with EU practices, should be included in the definition of technical losses of the distribution system but should be part of the gas supply cost.